Xerium Technologies: A Recurring Revenue Business at 4x Cash EPS

| About: Xerium Technologies, (XRM)

Xerium Technologies, Inc. (NYSE:XRM) ("Xerium" or the "Company") is a post-bankruptcy equity trading at roughly 4x forward cash EPS. The Company returned to the equity market in late May 2010, after spending just a few weeks in bankruptcy following a pre-pack with its bank debt holders. Despite having shown good operating traction over the last couple of quarters, the Company remains a public market orphan, with no sell-side coverage and relatively limited liquidity. As the Company continues to make both financial and operating progress over the next several quarters, as the one-off charges related to the bankruptcy abate, and as debt holders that were equitized as part of the pre-pack monetize a portion of their holdings, I expect both trading liquidity and the Company's market profile to improve, and the unsustainably low valuation to appreciate.

Xerium has two primary products, both of which are sold to paper manufacturers. The first, accounting for roughly 2/3 of revenue, is paper machine clothing. Paper machine clothing is a highly specialized woven textile belt that drains processing water and transports paper through the paper making machines. The clothing is an advanced textile that is instrumental to paper quality, and is in increasing demand with new, higher tech paper machines. The second product, accounting for the bulk of remaining revenue, is roll covers. Roll covers are rubber or synthetic coatings that are affixed to paper machine rolls. The roll covers support and guide the paper machine clothing through the paper machine. Both products are consumables, with clothing replaced on average every 12 weeks, and roll covers replaced on average every 1-2 years. Xerium is a leader in both segments, with a 15% market share in clothing (#2 globally ) and a 33% market share in roll covers (#1 globally).

Paper manufacturing is a cyclical business, and the down cycle that was driven by the global recession in late 2008 and early 2009 proved to be too much for the Company's highly levered balance sheet to handle. Customers drew down their inventories of clothing and roll covers as they awaited better visibility on demand, and annual run-rate revenues for Xerium declined from a peak of roughly $660mm (with $140mm of EBITDA) in early 2008 to just $460mm in early 2009. Xerium went through a pre-pack, both entering and emerging in May 2010, with bank debt holders emerging with an 82% equity stake in the reorganized Company. Subsequently, revenue and EBITDA have improved, and are now run-rating roughly $540mm and $100mm, respectively. Given the large number of restructuring and bankruptcy-related charges that have been running through the income statement for the last several quarters, the EBITDA run-rate is far from clear to those who don't take time to dig into the Company's financials. With most of these charges now behind the Company, its cash generating power should begin to screen more easily.

Paper manufacturing, and by extension Xerium's business, is a slow growth market, typically growing roughly in-line with global GDP. The US and Europe are expected to be flat for the next several years, with most global growth being driven by Asia. In this slow-growth environment, Xerium is focused on driving incremental growth primarily through market share gains as a result of increased new product introductions. New products as a % of total sales have increased from 19% in 2008 to 30% currently, and the Company's target is to get to 60% by 2012. This renewed R&D focus, meanwhile, is taking place while the Company's top competitor, Albany International (NYSE:AIN), has publicly stated on multiple occasions that it plans to use its machine clothing business as a cash cow to fund its other, higher growth businesses. Thus, the competitive environment seems favorable for Xerium's plans. In addition, the Company is finally getting some pricing tailwind. After pricing its products aggressively through the bankruptcy process in order to retain customers, the Company has recently returned to more rational pricing and in 2Q 2010 saw a positive, albeit very small, year-to-year trend in overall pricing. Order bookings have been trending positively on a consistent basis since the 2nd half of 2009, and by all accounts are being driven by growth in end market paper demand, as opposed to inventory restocking.

Gross debt, as a result of the restructuring, has declined from $640mm at year-end 2009 to $475mm currently. The Company still remains relatively levered, with estimated EBITDA to interest expense of about 3x for 2011, but given the steadily improving demand metrics and recurring nature of the Company's revenue base, the leverage should be easily manageable. Debt amortization is modest, with required repayments of under $10mm annually. The Company's two term loans mature in 2014 and 2015, respectively. Management has been focused over the last several years on reducing the business' working capital intensity. Working capital as a % of revenue has been reduced from nearly 30% a year ago to 24% in the most recent quarter, and management is working on freeing roughly $30mm of additional cash that is currently tied up in working capital.

Xerium's top 3 shareholders currently are American Securities, Carl Marks Management, and Third Point. American Securities and Carl Marks both established their equity interests through the debt, while Third Point has been a buyer subsequent to the reorganization.

The management team has publicly refused to use the Company's reorganization plan as a target for Company guidance. That said, the Board of Directors recently affirmed that it was using the plan as its baseline for incentive based comp, providing some comfort that internally at least the plan is still viewed as reasonable. The reorganization plan has Xerium doing $112mm and $126mm of normalized EBITDA in 2010 and 2011, respectively. With the current capital structure, that would imply nearly $2/shr in EPS (note that $126mm in EBITDA is well off the Company's historical peak of $165mm in 2008, implying considerable upside to the extent a more normalized demand environment returns).

The Company runs a consistent favorable spread between capex and D&A of roughly $15mm, as the economic life of the Company's machinery is far, far longer than the accounting life. This spread contributes an additional $1/shr to my cash earnings number, yielding nearly $3/shr for 2011. Moreover, this number actually understates potential free cash generation, as the Company was able to preserve $90mm of Federal NOLs through the bankruptcy process, and should generate roughly $45mm additional this year as a result of bankruptcy-related write-downs. This $135mm of resulting Federal NOLs will allow the Company to shield 3-4 years of cash tax payments. So today, Xerium trades at roughly 4x forward cash EPS, and about 4.5x forward EBITDA.

So to summarize, today you can purchase Xerium, a well-entrenched recurring revenue business operating in a favorable competitive environment, for roughly 4x forward cash EPS. As a function of i) its valuation, ii) improving operational and financial trends, iii) increasing clarity on the true run-rate EBITDA and EPS power of the business as one-off charges cease, and iv) increased investor attention as the bankruptcy stigma wears off, its status today as a public equity market orphan shouldn't last for long.

Disclosure: Long XRM